The Importance of an ESG Policy for Hedge Fund Managers: An Interview with BKD’s Dirk Cockrum & Brian Matlock
By now, you’ve probably seen environmental, social, and governance (ESG) issues hitting industry headlines on a regular basis. Investors have made it clear: ESG is no longer just the buzzword it started as when the faint whispers of that now famous acronym began circulating in the investment industry. Hedge fund managers need to pay attention and be aware of its implications, the challenges with implementing an ESG program, and the importance of an ESG policy. Now is the time to act, not the time to observe and wait.
BKD ESG Consulting Practice Leader and Managing Director Dirk Cockrum and National Industry Partner Brian Matlock sat down with HFM to discuss.
Why is an ESG policy important for hedge funds?
Dirk Cockrum: ESG has been one of the fastest-growing areas for investors now for several years. It’s important for hedge funds to have a policy because institutional investors are increasingly signing up to the Principles of Responsible Investment (PRI) and making a commitment to incorporate ESG into their investment analysis and decision-making process. Some investors are moving into ESG slowly, but if you don’t have an ESG policy, or are only just considering ESG, it can be increasingly difficult to attract capital from those investors, if at all.
Finally, if you’re a hedge fund manager who believes good ESG performance leads to good financial performance, you’ll understand that sometimes, if they’re overpriced, great companies aren’t always good short-term investments. But if you take a longer-term perspective, there is alpha to be had if you can develop the capabilities to identify good ESG practices.
What do investors expect from hedge funds when it comes to ESG?
Dirk Cockrum: It depends a lot on the investor. There is a baseline. With any investor, they're looking for good stewards for their money and a risk return profile that fits what they’re targeting. Increasingly, however, there’s a minimum level of ESG that investors want considered in the investment process. Beyond that, it really depends on what specific investors are looking for.
For example, if they want exposure to the entire market, one way to approach it is a best-in-class approach; invest in the best ESG performers in each industry. Alternatively, if you’ve got investors who don’t want to be in certain sectors like firearms or tobacco, then you need a different policy. You need a screening filter for that approach.
There is a broad range of expectations. That’s really what you’re seeing in the marketplace in terms of offerings: a proliferation of ESG products that can meet those different investors’ wants and needs.
How is the SEC’s thinking on ESG changing?
Brian Matlock: The SEC has an enforcement approach to ESG. It likes formal, documented policies and procedures, that you have good controls, and that you can demonstrate you follow them. You’ve got to be careful how you react to that—you don’t want to go overboard and stifle your analyst with written policies and procedures. But there’s a nice middle ground where you can provide good documentation for an examiner and clarify with your analysts and management what you’re wanting them to do to find potential investments.
The SEC also is signalling to expect a rule specific to climate-related disclosure modelled after the Task Force on Climate-Related Financial Disclosures (TCFD) regulations.
In the U.S., regulatory rulemaking is very much a sausage-making process, so you never know what the regulation is going to be until it’s published. Even then, there can be litigation and a lot of uncertainty around new requirements. But if the SEC adopts TCFD, it will likely be different from what we are used to from the SEC.
Existing disclosure rules lead to a lot of boilerplate disclosures; one company’s disclosure looks a lot like the other. TCFD recommendations are much more entity-specific in disclosing risks and opportunities, how you manage them, and what metrics you use to measure them. That’s a lot more there than most people are used to.
What does a lack of ESG standardization mean for hedge funds?
Dirk Cockrum: You’re never going to be able to meet all investors’ expectations, and the lack of standardization is a challenge. It’s also an opportunity.
In traditional credit ratings, the ratings firms tend to track each other; the timing may be different, but they tend to be pretty well aligned. With ESG ratings, the raters often are not aligned. They might have the same data, and one ESG ratings firm will rate a company as a great company while the other ESG ratings firm will rate the same company as poor.
If you’re a glass-half-full person, you say, “Hey, there’s an opportunity to grab alpha.” If you can create the capabilities to identify good ESG performers that are not priced into the market yet, then the lack of standardization can work to your advantage.
How can a four-phase approach to ESG help hedge funds?
Brian Matlock: ESG is such a big word, and it means a lot of different things to different people. The four-phase approach that we designed really helps break it down to its components so it’s a lot easier to think through. Effectively, it’s an “assess,” “design,” “implement,” and “monitor” approach.
“Assess” is the first phase and probably the most crucial. It’s a point at which management decides this is important and wants to move forward with it but, more importantly, decides what its approach looks like. That’s where management starts a dialogue internally with the executive leadership and externally with stakeholders, such as institutions and investors. It’s also where you identify your key performance indicators (KPI) and different risks and opportunities.
The next phase is the "design" phase, which is just as important. That’s where you take all the data you’ve collected in the assess phase and really start to develop a plan to message that to your constituents. You’re going to start thinking about how you gather data, how you measure it, and what you want your ESG report to look like.
The next two phases are “implement” and “monitor.” Implement is simply that—it’s to execute the message. The implementation phase is something that never stops. You’re implementing daily.
The monitor phase is probably the most important to stakeholders. There are different avenues you can use to report that. Are you reporting it within your audited financial statements? Are you reporting it on a website? One of the things that’s obviously very important right now with the SEC is that you’re not only reporting the data but being truthful. It’s something that can be tested and monitored, and something that auditors can attest to. At BKD, we have an auditing group that can verify the ESG information is reliable and render an opinion.
How important is it to monitor your ESG policy and help it evolve?
Brian Matlock: It’s not a one-size-fits-all approach. It depends on the size and complexity of the ESG program. Monitoring can be fairly simple, or it can be extremely complex. What we have seen historically is that you may have your ESG board—which may just be your general partner and some of the managers of the fund—meeting quarterly to assess whether the information being provided is still relevant. Do things need to be added or taken away? And then annual reporting to external stakeholders can range from a fairly thick document to just a few paragraphs within your annual report. We’ve seen both extremes. It depends on what your investors want to see. If they’re large institutions that that have a lot of KPIs they’re measuring, then a more robust report is probably needed. If they’re smaller, such as individual or family office groups, they’re not as concerned generally about those robust ESG reports.
What should hedge fund managers look for in an ESG consultant?
Dirk Cockrum: At BKD, we really pride ourselves in listening to our clients and translating that into something that’s valuable to them. We really like to work with clients to reveal their underlying needs and wants, e.g., the root causes of why they’re looking for help. Then we take that insight and marry it up with our experience and knowledge to develop solutions that help solve problems.
Great consultants should be able to anticipate what their clients’ needs are going to be in the future and try to look for things that are going to provide value. You want your clients to be successful and get ahead, so that anticipation of a hedge fund manager’s needs as they change is something we work hard to do as well.